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Course 401
Shades of Value

Introduction

Everyone has a different definition of value. For example, you and your best friend are comparing footwear (or grocery stores, plumbing services, or even housing). You call your shoes a deal because you got them on sale 50% off! Your friend, meanwhile, considers her shoes a value buy simply because she paid less than she would have for a comparable brand.

Fund managers who buy value stocks express similar differences of opinion. All value managers buy stocks that they believe are worth significantly more than the current share price, but they tend to argue about just what makes a stock a good deal. How a manager defines value will determine what his or her portfolio includes and, ultimately, how the fund performs.

Why Shadings Matter

Consider the following as a great example of why investors need to understand how their fund managers define value. Schneider Value (SCMLX) and Forester Value (FVALX) are both large-cap funds that fall into the value side of the Morningstar Style Box, but their performances over the past three years through June 2011 have been startlingly different. Schneider has lost 8.6%, landing in the category's basement, while Forester Value has gained 7.3%, making it a top category performer over the trailing time period.

What made the difference? Different definitions of value and different strategies. Arnie Schneider III, manager of Schneider Value, and his team use fundamental research to identify both struggling companies and industries in a rough patch. He often invests in companies going through management changes, strategy shifts, or cost cuts, and pays dirt-cheap valuations. That strategy has paid off in the past, but the fund's gutsy approach has also backfired at times. Owning--and adding to--the likes of Fannie Mae, Freddie Mac, and Countrywide during the market meltdown were among Schneider's worst moves.

Meanwhile, Tom Forester of Forester Value also looks for attractive valuations and scans for historically low P/E, price/cash flow, and price/book ratios as well as companies that pay dividends. Once he finds a cheap company, though, he will only buy if it has a solid balance sheet, good competitive position, and historical earnings per share and dividend growth. In 2008, Forester held a significant cash stake as he waited for bargains to appear, allowing him to beat the pack during the depths of the downturn.

On the flip side, during market rallies, Forester Value's conservatism can cause the fund to badly lag (and often it had ended up in the category's basement in bull markets). Schneider Value, on the other hand, can roar back during speculative market rallies, as its deeply out-of-favor names bounce back hard.

So, although both funds are value vehicles, the execution is vastly different, and can lead to strikingly different performance profiles. Thus, it is important to dig beyond the style box to truly understand how a fund is run and what kind of performance you may expect in different market environments.

Relative Value

Value strategies roughly divide into the relative-value and absolute-value camps. Not surprisingly, there are a lot of variations within each group.

Fund managers practicing relative-value strategies compare a stock's price ratios (such as price/earnings, price/book, or price/sales) with a benchmark and then make a decision about the firm's prospects. In other words, value is relative. These benchmarks can include one or more of the following:

The Stock's Historical Price Ratios

Companies selling for lower ratios than usual can be attractive buys for value managers. Often, these companies' prices are lower due to some "bad news," to which the market often overreacts. Some value managers have picked up Cisco (CSCO) in late 2010 and early 2011, for example, as a string of recent earnings misses have soured investor sentiment on the firm. But many believe that management's commitment to refocus the firm on its core operations will make the sell-off seem overdone.

The Company's Industry or Subsector

A manager may believe that a company is undeservedly cheap compared with its competitors. For example, Goldman Sachs Large Cap Value looks for stocks on an industry-by-industry basis, seeking companies that are trading cheaply relative to their industry peers. The fund also limits sector bets to within a few percentage points of the Russell 1000 Value Index.

Funds that look for companies that are cheap relative to their industry peers may well take on more price risk than absolute-value funds. For example, in early 2000, even though the technology sector as a whole was dramatically overvalued, a relative-value manager, or a manager that needed to maintain a certain percentage in each sector according to an index benchmark, might have continued buying technology stocks that appeared cheap relative to other technology stocks. Meanwhile, value managers following a different approach might have avoided technology altogether.

The Market

In this case, managers look for companies that appear attractively valued relative to the broader equity market, not just their industry peer groups. For such a manager, technology stocks wouldn't have been a likely place to find bargains in early 2000, even though many would have filled the bill for a manager seeking companies that were merely cheap relative to their industry peers.

For these managers, a company may be attractively valued because of issues specific to its own operations that have depressed its share price or because it's in an out-of-favor industry. This scenario is common with cyclical sectors, such as industrials or consumer discretionary names.

Absolute Value

Managers such as the team at Longleaf Partners (LLPFX) follow an absolute-value strategy. They don't compare a stock's price ratios with something else. Rather, they try to figure out what a company is worth in absolute terms, and they want to pay less than that figure for the stock.

Absolute-value managers determine a company's worth using a variety of factors, including the company's assets, balance sheet, and likely future earnings or cash flows. They may also study what private buyers have paid for similar companies.

At Longleaf, the managers look for companies that trade at discounts of 40% or more to the team's estimates of their intrinsic value, using discounted cash-flow analysis, asset values, or sales of comparable firms to determine the latter. The managers place much importance on the ability of a company's management to run the business on an operational level and to effectively allocate capital. They often take sizable positions, and the fund typically holds 20-25 names. The turnover rate is typically very low.

Because of this approach, the Longleaf portfolio isn't broadly diversified, and its concentrated approach means that trouble in a few top holdings can have a significant negative impact on returns. Indeed, for six of the past seven years (as of early 2011), the fund has landed in either the top decile or bottom decile of the large-blend category. However, over the long term (10- and 15-year periods), the fund lands solidly in the top 10% of its category.

This case study illustrates the patience required of investors in an absolute value fund. Because such a fund may look very different than the broad market, and its performance may deviate as a result, it can look very out of step over shorter time periods. Of course, some absolute value funds are better than others, but even the best absolute value funds can be misused by investors who can't stomach the rougher ride.

When Value Managers Sell

There are two chief reasons value managers will sell a stock: It stops being a value, or they realize that they made a bad stock pick.

Stocks stop being good values when they become what managers call fairly valued. That means that the stock is no longer cheap by whatever value measure the manager uses. For relative-value managers, that could mean that the stock has gained so much that its price ratios are now in line with industry norms. For an absolute-value manager, that could mean that the stock's price now reflects the absolute worth the manager has placed on the company.

A manager may also sell a stock because it looks less promising than it did initially. In particular, new developments may lead the manager to a less favorable evaluation of the company. Nevertheless, if the stock's price drops but the manager believes the company itself is still attractive, that may be a chance to buy even more of it.

Quiz 401
There is only one correct answer to each question.

1 All value managers:
a. Buy stocks that they believe are worth significantly more than the current price.
b. Buy stocks whose price/earnings ratios are below the market's price/earnings ratio.
c. Buy stocks whose price/book ratios are below their historical levels.
2 Relative-value managers:
a. Buy stocks that are cheaper than the company's entire worth.
b. Buy stocks trading below their historical price ratios, their industry peers, or the market.
c. Seek high growth.
3 Absolute-value managers:
a. Buy stocks that are cheaper than what they deem to be the company's entire worth.
b. Buy stocks trading below their historical price ratios, their industry peers, or the market.
c. Seek high growth.
4 Which statement is true?
a. All absolute-value managers calculate a company's worth the same way.
b. Absolute value funds offer a smooth ride because they seek undervalued companies.
c. Absolute value funds require patience because management's concentrated style can lead to ups and downs in the short term.
5 If a stock is fairly valued, what does that mean?
a. The stock is no longer cheap by whatever benchmark the manager uses.
b. The stock has gained so much that its price/book ratio is now in line with that of its industry.
c. The stock's price currently reflects the absolute worth the manager has estimated for the company.
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